Mutual Fund

AT1 & Tier II Bond Risks hiding in plain sight!

“The best approach here, if at all possible, is to use supervisory and regulatory methods to restrain undue risk-taking and to make sure the system is resilient in case an asset-price bubble bursts in the future.” Ben Bernanke

I am a strong believer that the Indian financial regulatory environment is managed quite well. The way Indian banks are regulated and monitored, it has resulted in the history such that no consumer of a bank has faced the loss of capital over last 2 decades. Even though the bank failures/ mergers have happened, still it has been a largely salvageable situation. In recent times, banks like Yes bank or Lakshmi Vilas bank has gone through the restructuring and it has exposed one of the risk associated with the Additional Tier 1 (AT1) bonds. Recognizing the same risk, SEBI has come out with a proactive regulation to limit this risk exposure for Mutual Fund investors. This in my view, is a very welcome move as a regulator to protect the retail investors capital.

SEBI in it’s circular dated Mar 10, 2021 has addressed this issue. Currently, There is no limit on exposure to such bonds by AMCs in their funds. SEBI has prescribed that Any AMC should not own more than 10% of such instruments issued by a single issuer. Also, Individual Mutual Fund scheme shall not invest more than 10% of its NAV of the debt portfolio of the scheme in such instruments and shall not have more than 5% of its NAV of the debt portfolio of the scheme in such instruments issued by a single issuer. These are significant limits as in current situation there are 22 funds that have over 10% exposure to AT1 and perpetual bonds as on February 2021. (Source: Morningstar India) As per the regulation, the current exposure would be grandfathered and AMCs can make fresh investments in the perpetual bonds only once their exposure comes within the prescribed limits.

Though the clause of grandfathering would not be much useful for debt funds which have restriction on their Macaulay duration like Low/ short or Medium duration bond funds as per Oct 2017 circular by SEBI. As the AMCs have to value the perpetual funds with maturity of 100 years, the Macaulay duration is set to be changed drastically. Even though the clarification given on Mar 22, 2021 has updated the maturity applied to increase in phased manner, still the impact might be significant.

For e.g. the Low duration funds should have Macaulay duration of less than 1 yr. HDFC Low duration fund has exposure of 11.74% to perpetual bonds. One such bond is STATE BK OF INDIA 8.75% S-II perpetual bond. The bond has the issuer call option for Sep 2021, which means if issuer calls to redeem this bond it will mature is 5 months from today so it’s maturity is <1yr. Though if we have to calculate the Macaulay duration of this bond as per new regulation the maturity as 10years & expected YTM of 8.7% for AA+ category bonds, it comes out to be 7.06years. Therefore, 12% exposure in 7Yrs Macaulay duration would make the portfolio Macaulay duration of 12% * 7 = 0.84 and this means the fund should have the remaining 88% of the portfolio with maturity of <0.2years. This is quite difficult to achieve and the fund have to make lot of changes to adhere to the new regulation of valuation of perpetual bonds along with maintaining the Macaulay duration of <1yr.

As I have mentioned earlier (Investing in TINY world) that at present it does not make sense for having duration exposure in your portfolio. The current regulatory change would increase your exposure to interest rate risk. You should review your funds in your holding and probably opt for one of the actions as per me. Exit should be done in optimal manner to have lower tax/ exit load impact.

  • If the portfolio holds <5% of assets in form of perpetual bonds, you should not worry and consider the fluctuations in it’s NAV as part of market risk you have signed for
  • If the exposure is 5-15%, and your debt fund is of Low/ Short/ Ultra Short duration or 15%-20% in your Banking PSU/ Medium duration fund then there is problem as the fund has to value funds with assumed maturity of 10 years in short run. This will increase the interest rate risk as well as Macaulay duration of the fund so the fund houses might have to reduce the exposure. This would have an impact on NAV and if you have a really large exposure, you should contemplate reducing your holdings (Speak to your advisor/ distributor)
  • If your fund has >20% exposure & your have significant investment in such fund than consider to get out of such fund

It is important as an investor to understand such products in details. Attached link shares the details of such perpetual bonds, which clearly states its risk (refer the term sheet from page 78). These bonds are Non-convertible, Perpetual, Taxable, Subordinated, Unsecured. each term in it’s definition poses a risk. If you thought that the interest rate on bonds is higher and probably covers for the risk, I would recommend to read page 86 for Coupon Discretion & Page 88 for Loss Absorbency. The coupon is discretionary as well and if issuer needs to cancel the coupon, it can with no recourse available to bond holders. Hope this helps you understand the positive intent of SEBI to limit exposure to such bonds.

Lastly, Don’t just think that the regulation is going to impact just the debt funds. It will also impact your Hybrid aggressive funds as well. Even though there is no Macaulay duration limit applicable to such funds, They would have to comply with the 10% upper limit of exposure in the debt portfolio. In simple terms, I would interpret this as follows: “If the Hybrid Aggressive fund has 25% exposure to debt than no more than 2.5% of the portfolio should be in perpetual bonds.” If my interpretation is correct, this might be a bigger trigger of upheavals in aggressive fund category as all of the Top 3 funds (SBI Eq Hybrid/ HDFC Hybrid Eq & ICICI Pru Eq & Debt) by AUM have >3% exposure to perpetual bond funds. ICICI Prudential Eq & Hybrid has the higher exposure among the three funds 9.53% of the fund AUM as of Feb 2021. Similar would be the story in Balanced advantage funds or conservative hybrid funds.

In Summary, Please do no invest and forget your investments. Keep monitoring for the impact of such regulatory changes and make the necessary amends in your portfolio. If you find it difficult to monitor your portfolio at your end, speak to your advisor or distributor to understand such impacts or stick to simple products for investments which avoid such risks. It is your money and your responsibility to monitor the same. Happy Investing!

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